Sluggish Mega-Caps Are Weighing on Tech

Has Big Tech become defensive, or are investors just sour?

For years, the tech sector was the place investors could go to pick up some beta and gain excess return in rising markets, but recent months have brought a substantial departure from that historical trend.

Since the most recent market low on Nov. 15, the Technology SPDR (NYSE:XLK) has gained 10% but trailed the 15.5% return of SPDR S&P 500 ETF (NYSE:SPY) by a wide margin. The other major technology ETFs have followed suit: Vanguard Information Technology ETF (NYSE:VGT) and iShares Dow Jones U.S. Technology Sector Index Fund (NYSE:IYW) have returned 11.4% and 9.7%, respectively, while PowerShares QQQ Trust (NASDAQ:QQQ) is up 11%.

Before jumping to conclusions about what this might mean, it’s necessary to drill down and take a closer look at what’s going on underneath the surface.

One of the largest causes of tech’s underperformance is, of course, the downturn in Apple (NASDAQ:AAPL), which stands more than 11% below its mid-November level despite its recent rally. This has been a major drag on any fund or index tied to the tech sector’s capitalization-weighted performance.

While Apple gets the most attention, it isn’t alone among the sector’s mega-caps in terms of its underperformance. Since the Nov. 15 low, Microsoft (NASDAQ:MSFT), Oracle (NASDAQ:ORCL), eBay (NASDAQ:EBAY), Intel (NASDAQ:INTC), Qualcomm (NASDAQ:QCOM) and EMC (NYSE:EMC) have all underperformed the S&P 500. Among the 10 largest tech stocks, in fact, only Cisco (NASDAQ:CSCO) and Google (NASDAQ:GOOG) have managed to outperform.

Outside of this top 10 , it’s a different story. The average tech stock has performed much better than the mega-cap group, with many outpacing the broader market return by a wide margin. And you don’t have to go too far down the market-cap range to find the winners. Among the U.S. tech stocks ranked 11-20 in terms of market cap, nine have performed in line with or better than the S&P since mid-November, with Texas Instruments (NASDAQ:TXN) the only laggard.

In this sense, technology is no different from the market as a whole. In the past four months, mid- and small-cap stocks have trounced their mega- and large-cap counterparts in the risk-on environment. With tech, however, this impact is magnified due to the fact that the top 10 holdings tend to be much more heavily weighted than they do in other sectors — and that includes heavy allocations to mature, slow-growing companies such as Microsoft and Intel.

This impact can be seen clearly in the underperformance of the iShares tech ETF in relation to VGT, the latter of which has about 25% of its assets in small- and midcap stocks. Along that same line, the Guggenheim S&P 500 Equal Weight Technology ETF (NYSE:RYT) has gained 16.2% since Nov. 15 — well above XLK and better than the S&P 500. As its name suggests, the fund seeks to maintain an equal weighting in all of its holdings rather than affording larger weightings to stocks with larger market caps.

The next test for technology will come when the broader market finally corrects. If the sector’s mega-caps hold up better than the market as a whole, it will be a sign that this has — in the aggregate — become a more defensive group that may join the ranks of “steady Eddies,” such as the giants in the consumer staples sector.

Conversely, underperformance would be a signal that investors truly have grown more lukewarm on the prospects for big tech. While this is less of an issue for those who own on individual stocks, it’s one of the most important considerations for investors in QQQ and cap-weighted technology ETFs as we move into the second quarter — a time that has brought poor market performance for three years running.

As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.